When a bank forecloses on commercial property (or has the option to foreclose) there is always a question of do you spend energy working out the property in hopes that the value comes back or do you sell the property and take the capital charge? To answer the question, we looked at analysis on 150 loans whose underlying financed properties had payment problem and analyzed appraised values over a period of time to determine when a bank should either push the borrower to liquidate the property or foreclose and liquidate the property themselves. The good news is that the data shows a clear dominate strategy.
Before we get to what that strategy is, we caveat the analysis. First, it should be noted that we looked at only loans that had payment issues and not loans that were in technical default for other non-cash flow reasons. Second, we looked at appraised valuations, not actual property sale value (since not all troubled property was sold). Third, we grouped all properties together regardless of the date of origination. Fourth, we started the analysis, not at the start of the recession, but when there were first signs of property deterioration (more on this point later). Fifth, we did not include any analysis of the borrower or guarantors, as we wanted to focus purely on property values. Finally, it should be known that we assumed the latest data from 1Q 2015 is near the end of the property deterioration cycle since most distressed properties have now stopped losing further value. While we could be wrong on this last assumption, the direction and the findings of the analysis should continue to hold.
What The Data Shows
The answer to the title question is, on average, banks should sell or influence a sale of the property at the earliest opportunity. Of course, the real big disclaimer here is that every situation is different so be sure to conduct your own analysis, but if all other factors are equal, as a rule of thumb get out of the trouble at the soonest possible time, as in a recession, the sooner you do, the better off you will be.
You can improve performance from the above statement by categorizing all properties with operational, property level problems such as buildings that were hit by a disaster (i.e. flood), buildings that have engineering-related problems (i.e. problems with their heating/air) or legal issues (i.e. partnership lawsuits) as these issues occurred in 18% of the cases with mixed outcomes that appear uncorrelated to time.
However, for the remaining 82% property values deteriorate quickly and consistently when economic problems occur. An analysis of appraised values of troubled properties show that approximately 33% of the value is lost in the first year followed by a 31% loss in the second year. After the third year, property values tend to moderate but still drop 17%, followed by a drop of 11% in year four, 6% in year five and 3 percent in year six. To recap, approximately 64% of the property’s value is lost in the first two years. Thus, in our analysis, banks that hesitated, suffered larger losses the longer they held onto the property. Not only did property values fail to come back up, but also the bank suffered workout expenses, time, energy and loss of focus. In very few cases that we reviewed was the bank better off waiting to workout the property unless the problems were for clear temporary reasons.
But, how can this be, when the average commercial property price is over 12% from the peak of the recession?
This Is The Key Point To Understand (And the Decision Bias To Recognize)
While it is true that every commercial property category fell during the recession with most hitting the bottom around late 2009 before a steady climb up. Further, it is also true that almost every commercial property category is now above their peak price last achieved around mid to late 2007. Thus, when looking at the data, many bankers reach the conclusion that if the borrower defaulted around 2009 (many did), then it would have been better to hold onto the property for a year and then sell at a higher price. The issue is one of selection bias.
While properties that default do follow the general market trends on the way down, they don’t follow the trends on the way up. Properties that default usually have a material issue with them. Usually, it is the location, sometimes the design, and sometimes the construction. When it comes to location, the number one issue category, usually it is in a tertiary market that is not large enough to follow general real estate trends or the property address was not suitable for marketing. Whatever the case, loans on commercial properties that defaulted are adversely selected and usually have issues. Thus, when a bank has a defaulted loan, it is usually the case that there is more going on than just the general economy. An improving economy helps a bad property, but it is usually not enough to solve a bankers problems and in a majority of cases, values got worse.
One last piece of the analysis that bears highlighting. When analyzing the last recession, it was interesting to note that while the early warning signs appeared in late 2007, it took the commercial real estate market almost a full 15 months to register any material decline in appraised values. Thus, banks that were on top of real estate monitoring knew they had a problem by April of 2008, as liquidity dried up and credit spreads doubled. Banks that moved to work out troubled properties in 2008 (either by design or luck), did substantially better than banks that were slow to recognize their issues or made the decision to hold of on forcing the borrower into foreclosure.
Submitted by Chris Nichols on July 20, 2015